CAPITAL INVESTMENT ANALYSIS IN THE PUBLIC SECTOR
UNIT 4 CAPITAL INVESTMENT ANALYSIS IN THE PUBLIC SECTOR
3.0 Main Content
3.1 Concept of Capital Budgeting
3.2 Capital Budgeting Factors
3.2.1 Capital Budgeting Decision Steps
3.2.2 Capital Budgeting Tool in Public Sector
3.3 Cost –Benefit Analysis (CBA)
3.3.1 Cost-Benefit Analysis- Process
3.4 Evaluation of Costs-Benefits and Project Selection
3.4.1 Risk Evaluation in Cost-Benefit Analysis
3.5 The Cost of Capital in Cost Benefit Analysis
3.6 Project Management-Planning and Nature of Project
3.6.1 The Network-Diagram and Convention
3.6.2 Total Project Time: Critical Path Method (CPM)
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Reading
1.0 INTRODUCTION
In this unit, we shall attempt to discuss capital budgeting via cost-benefit analysis as applied to the public sector. The private sector objective is always expressed in financial terms while the principal objective of a public sector enterprise is not necessarily financial. Political and social consideration over-ride financial objective in the public sector.
You would be led through project management using network analysis in executing government project.
2.0 OBJECTIVES
At the end of this unit, you should be able to:
explain the concept of Capital Budgeting apply capital budget tool in Public Sector describe the process in Government Projects identify its impact on Government Decisions evaluate cost-Benefit Analysis and Project Selection discuss Project Planning-Management explain Network in Project Development.
3.0 MAIN CONTENT
3.1 Concept of Capital Budgeting
According to Hampton (1992), capital budgeting is the decision making process by firms evaluate the purchase of major fixed assets including buildings, equipment, stocks etc.
Capital Budgeting is also the act of long term planning decision for investment and financing of fixed assets, evaluating capital expenditure. The primary objective in capital budgeting decision is to add value to an going concern (private or public) by selecting investments/projects that meet the goals of the organisation and provide best possible rates of return. There are many techniques of capital budgeting: Investment appraisal techniques like:
Traditional Methods (Non-discounted)-Pay-back, Accounting Rate Return.
Modern Methods (Discounted)-Net Present Value, Internal Rate of Return Profitability Index, Discounted Payback Period.
Capital Rationing and Risk Analysis. Cost-Benefit Analysis.
SELF-ASSESSMENT EXERCISE 1
List the various techniques of capital budgeting.
3.2 Capital Budgeting Factors
The following factors may influence capital budgeting decision:
Economic Change- is very dynamic. Technological Change- is very rapid. Political Change- is ever presence. Social Change- societal values, norms and orientation change. Financing Capacity- capability and policy thrust is considered. Future Prospects- provision for future growth is considered.
3.2.1 Capital Budgeting Decision Steps
Identify possible investment projects. Acquire from the data on the projects under consideration. Evaluate the projects from the data assembled. Identify possible alternative to the projects being evaluated. Select project. Implement project. Monitor and control project.
3.2.2 Capital Budgeting Tool in Public Sector
Government at whatever level might want to provide certain standard or service to the citizens at a charge below cost:
It may be through subsidising the industry and accepting loss from the industry example postal services etc.
This makes the capital investment analysis most at time since the public sector different from that of the private sector.
Cost Benefit Analysis (CBA) proffers a better approach to analysis of projects in the public sector (Federal, State and Local Government).
Cost Benefit Analysis is the most widely used technique
SELF-ASSESSMENT EXERCISE 2
State the steps taken in capital budgeting decision.
3.3 Cost –Benefit Analysis (CBA)
Public sector project might be done through the use of Cost-Benefit Analysis. This technique of CBA is drawn on the concept of Capital Budgeting as discussed above.
CBA is sophisticated technique that incorporates:
A number of issues such as environmental problems, opportunity costs and transfer prices.
Is more subjective than the normal capital budgeting technique especially forecasting of future outcomes of proposed project.
Attempts to consider all the consequences of embarking on a project.
Can be used to determine the viability of a project. Can be used to determine the time cycle that would be beneficial to the project. Can be assessed in terms of cash flow or profit (cash flow is preferable).
3.3.1 Cost-Benefits Analysis Process
Establish the objectives and possible advantages of a proposed project.
Ascertain alternative solutions to the problem. Estimate and analyse the cost and benefits (this is a wide
spectrum). Considers the costs and benefits that may accrue to anyone
outside the project. Example if government builds an airport, in addition to the costs
and benefits of building the airport, the ripple effect that will occur might include reduction in road accident, increase in commercial activities, tourist attraction e.t.c. Opportunity Costs: Opportunities forgone because of the project. Shadow prices the cost of obtaining an extra unit of a scarce resource. Transfer payments include subsidies and grants from a federal government fund to a state or local government funds.
3.4 Evaluation of Costs-Benefits and Project Selection
The government considers evaluating cost and benefit through various criteria namely:
Benefits/costs Comparison-comparing the costs with the benefits Benefits/cost Ratio-ratio estimated benefits to estimated costs Discounted Cash flow techniques-this includes the net present value and internal rate of return criteria- Both consider time value of money.
3.4.1 Risk Evaluation in Cost Benefit Analysis
CBA is a forward planning technique which involves forecasting. The acceptance or rejection of project depends on accuracy of the forecast of costs and benefits. The forecast might be guesses and not the accurate figure. There is risk in accurately forecasting in CBA
SELF-ASSESSMENT EXERCISE 3
Name the various criteria government considers evaluating Cost Benefit.
3.5 The Cost of Capital in Cost Benefit Analysis
The following considerations are used as cost of capital in the public sector as it is difficult to calculate using private sector approach of market value, no interest, business or financial risk in government activities;
The Social Time Preference rate: expresses the value which one places on consuming or owning an asset now as an
alternative to consuming or owning it in future. Government Borrowing and lending Rate: roughly the risk
free rate of interest. The interest rate on Treasury bills can be used
The Opportunity Cost Rate of Interests: If a project has been under taken at the expense of to another project, the rate of
interest that compensates for the capital being freed for the alternative project is called the opportunity cost rate of interest Real Cost of Capital: used where the government set a target real rate of return for projects.
3.6 Project Management-Planning
Management of a project involves planning expediently through coordinating efficiently the factors there in. Planning has not been given priority as projects were less complex; the rule of thumb method would work well. However, today, as projects have become more complex project managers and public administrators have associated themselves increasingly to systematic planning and management. This section of the unit will lead you through the complexity services and you will affirm the need for systemic outlay of projects.
Projects are in stages- a life cycle which include: planning, execution and phase- out At each stage of this life cycle, a variety of skillful requirements are involved. In effect:
Project unit human resources and with diverse knowledge and skills,
Some go from project to project as they are needed –consultants
In project management and planning, the size and scope of projects varies widely according to the nature and purpose of the project. It is worthy of note, that all projects have something in common. They go through a life cycle which can be arraigned into five phases:
Concept-the need for the project. Feasibility-expected costs-benefits analysis. Planning-details of work-human time and cost. Execution-ensure project. Termination-target achieved.
SELF-ASSESSMENT EXERCISE 4
List the processes involved in management of a project.
3.6.1 The Network: Symbols, Diagram and Convention
The first stage of analysis is to divide the project into a number of different activities. An activity is merely a particular piece of work identifiable as an entity within the project. If for example, the project under consideration is the servicing of a motor car, then one of the activities would be to check the brakes for wear.
Now an activity within a network is represented by an arrow, with the description of the activity written on it, as:
Check the brakes for wear
Note: In addition to activities, events are identified too.
Events mark the point in time when activity is completed and the next activity can be started. Events are normally represented by circles:
Network established
Network
A network is a convenient method of showing the logical sequence of activities in a project.
The event represents the point in time when activity is completed, but also represent the point in time when activity can begin.
The activities depend upon more than one activity or vice versa. The point of networking can be from one individual or source and terminates in dual results or contact points.
Dependence Tables
The first task of network analysis is to sort out the logical sequence of activity. This is done by constructing a dependency table by listing all
activities according to priority. For example, a financial manager can affect the volume of credit sales and collection period and consequently investment in accounts receivable. This is called a dependable change in credit policy.
Credit policy hence is used to refer to combination of decision variables like, initially, to start with credit standard, credit terms, and credit collection. The financial manager proceeding activity influences the activities thereof.
Constructing a dependence table (trend) is often the most difficult part of project analysis, hence, in public sector project management; experts are engaged as consultants in their different phases of the project.
Network Diagram
The network diagram below is composed of a number of arrows and notes. These arrows represent the flow of project activities. A network diagram is generally preferred to portray the project’s activities as follows:
The network diagram shows relationship among major activities of a project. For example, 0 to 1 has been completed, 1 to 2 is completed, 2 to 3 is also completed, and the circle has to be full by 1 to 3 which is the final spot and 3 to 4 is remote in to check if the project can start the test of time.
A path is a sequence of activities that leads from the starting nod to the finishing node. The project life cycle is equals to the expected time of the longest path. The longest path is the critical path because of the depth and value of activities involved for the completion of the project. There is always an allowable slippage for any path which is called slack and it reflects the difference between the length of a given path and the length of the critical path. The slack brings about flexibility in terms of implementation requirement.
3.6.2 Total Project Time: Critical Path Method (CPM)
The main determinant of Performance Evaluation Review Technique (PERT) and Critical Path Method (CPM) networks are analysed and interpreted as whether activity time or estimated are probabilistic or deterministic. If the time estimates can be made with the high degree of confidence, the actual time would not differ significantly. We say the estimates are deterministic. If estimated times are subject to variation, we say the estimates are probabilistic. Probabilistic time estimates include an indication of the extent of probable variation.
4.0 CONCLUSION
You were led through the application of capital budgeting via cost- benefit analysis in public sector financial management and the use of modern strategic planning in project management against the rule of thumb which was the order of the day in the years past.
5.0 SUMMARY
In summary of this unit, we have discussed the following; Concept of Capital Budgeting. Capital Budgeting Factors, Capital Budgeting Decision Steps, Capital Budgeting Tool in Public Sector, Cost –Benefit Analysis, Cost-Benefit Analysis- process, Evaluation of Costs-Benefits and Project Selection, Risk Evaluation in Cost-Benefit Analysis, The Cost of Capital in Cost Benefit Analysis, Project Management-Planning and Nature of Project, The Network-Diagram and Convention, Total Project Time: Critical Path Method and have shown how they are useful in the public sector despite associated limitations.
In the next unit, we shall discuss the definition of budget, its theory and practice, the objects of budgeting, the influence of Keynes, types of budgets and the processes involved in budget making.
6.0 TUTOR-MARKED ASSIGNMENT
1. Identify capital budget tool in Public Sector.
2. Discuss Project Planning and Management approach in public sector.